A new approach to do-it-yourself retirement planning

With the decline of traditional pensions, many older workers and retirees face a "do it yourself" retirement: You're on your own to figure out how to make your retirement savings last for the rest of your life. With retirements that can extend 20 to 30 years or more, this is indeed a daunting challenge for those who are fortunate enough to accumulate significant savings by the time they retire.

To address this challenge, different thinking and new language is needed to transition from a mindset concerned with accumulating assets for retirement to a mindset concerned with generating income in retirement.

To help with this mindset transition, you can apply portfolio concepts that people have successfully used to accumulate assets in building a portfolio of retirement income. You'll gain valuable insights about this strategy from a recent major study that's a collaboration between the Stanford Center on Longevity (SCL) and the Society of Actuaries (SOA). (Full disclosure: I was a co-author of this study, along with Wade Pfau and Joe Tomlinson.)

When you're saving for retirement, classic investment portfolio theory advocates that you allocate your savings among different types of asset classes, each having distinct characteristics and each expected to perform differently in up vs. down markets. This is called the "asset allocation decision." Applying this theory to asset accumulation means many retirement portfolios have a mix of stocks, bonds and cash investments. This is the common definition of "portfolio diversification."

When you're accumulating assets, investment risk is expressed as the possibility that your portfolio might lose money or not keep up with inflation. The goal of asset allocation is to minimize the odds of these undesirable outcomes over the time horizon that applies to you (typically until the age when you expect to retire).

But things get more complicated when you retire and need to use your savings to generate income for the rest of your life. To help meet your new goals, you can apply portfolio thinking by diversifying your sources of income among different types of retirement income generators (RIGs). You then allocate your retirement income among RIGs that not only perform differently in up vs. down markets but also have different characteristics when it comes to how long your income might last. They may also have other desirable features to meet different life circumstances. This is the "retirement income allocation decision."

Retirement income risk is then expressed as the possibility that the total amount of your retirement income would decrease by an undesirable amount or not keep up with inflation, or that you have insufficient liquid assets at any point. The goal of retirement income allocation is to minimize the odds of these undesirable outcomes for the rest of your life. The uncertainty about how long you'll live is one of the key challenges of retirement income planning.

Here are common goals that you may have for constructing your retirement income portfolio:

  • Generate a lifetime retirement income that you can't outlive.
  • Maximize the amount of retirement income you expect to be paid over your lifetime.
  • Minimize the odds that your total retirement income will fall below an undesirable level, usually due to stock market crashes.
  • Provide the potential for growth income to keep up with inflation.
  • Maintain access to savings in case of unforeseen expenses, such as medical or long-term care.
  • Preserve the ability to leave behind unused funds as a legacy.
  • Select investments that are easy to use and don't need continual monitoring and adjustment, or that protect you against fraud and mistakes (you'll appreciate this goal when you reach your 80s and beyond).

Unfortunately, no single RIG delivers on all these goals, so you'll need to prioritize and make trade-offs among them. Some goals may be more important to you than others. This is a valid argument for diversifying your retirement income sources, so your entire retirement income portfolio might address all the goals that are important to you.

Also, it's important to note that you might have different priorities and circumstances than your friends and family. So, take your needs, goals and circumstances into account when determining your retirement income allocation, not theirs.

Here are the common retirement income generators that have distinct characteristics regarding the above goals, each with different advantages and disadvantages:

Your task is to prioritize the goals that are most important to you, learn how each of these RIGs might meet those goals and then construct a portfolio of retirement income that increases the odds of success. It's a tall order, but nobody said do-it-yourself retirement would be easy. You may want to find a qualified retirement income planner who can help you and who'll have your best interests at heart.

This is just a summary of the main ideas from the SOA/SCL study, which is 80 pages of text and charts. This report can give you (or your advisor) valuable insights into constructing a retirement income portfolio that meets your unique goals and circumstances. And that might help you relax and enjoy your retirement.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.